Covered Calls

Resources

Getting Started

Market Wrap, Saturday, 12/31/2005

Trouble Ahead

by OI Staff

HAVING TROUBLE PRINTING?

When Santa fails to call, bear may come to Broad and Wall. Santa definitely
failed to appear and the outlook for January is rapidly turning negative. A
failure to rally during the last week of the year sends shivers through the
analyst community. The weakness was not due to a lack of cash with investors
sending $2.8B to mutual funds for the five days ended on Dec-28th. This was in
addition to the inflows of $4.9 billion in the
prior week. The drop was due to
profit taking by funds ahead of a potentially weak January.

Dow Chart - Daily

Nasdaq Chart - Daily

SPX Chart - Daily

The undercurrents are turning into a whirlpool as we approach 2006 and the
market weakness over the last week represented early exits by nervous funds.
Funds talk to each other and there is a real fear that January could see a
market reset as the year begins. The profits from the October lows will need to
be taken with markets stalling at the resistance highs. The S&P and
Wilshire-5000
both ran into a brick wall at 1275/12750 and five weeks of trading
failed to penetrate. The last week saw very little retail buying and every sell
program turned into a disaster in the low volume. Traders are seeing that 1275
level as a top and are waiting on the sidelines to see what January will bring.

For 2005 the year ended with a thud and were it not for the strong November
rally it would have been even worse. 2005 duplicated performance for 2004 with
weakness for
most of the year punctuated by a year-end bounce back to the highs.
Unfortunately that bounce was just enough to push the indexes back into the
green with the exception of the Dow. Note the slowing from the 2004 pace.

TTable of U.S. Indexes with Changes for 2005 and 2004

The -0.6% loss for the Dow was the smallest annual loss dating back
to 1902.
That is slim consolation for traders. With several dogs losing large amounts it
is amazing it was not worse. GM led that list by giving up -51% for the year.
That was offset in part by strong gains from HPQ, BA and MO. The gains shown for
AT&T in the table are skewed from the SBC/AT&T merger.

Table of Dow Components Sorted by Yearly Change

The poor performance by the U.S. markets is even worse than it appears when
compared to some other markets around the world. Granted some of the smaller
ones contain huge amounts of risk but you can see why international funds and
iShares have been so popular. Investing has taken on a global view for retail
traders more so than any other time in the past. Instead of being confined to
the 7500 U.S. stocks we can invest in an individual basket of stocks from
a
single country like Japan or trade a basket that covers all of Asia. The
investing world has changed and the ability to invest globally has taken cash
out of the U.S. markets that would have been fuel used in the past to push our
indexes higher.

Table of Global Indexes

Money flows into funds in general have been weaker than
in 2004. Overall stock
funds received $125.5 billion through November 30th compared to $167.6 billion
for the same period in 2004. This raised total assets of U.S. based mutual funds
to $8.76 trillion as of November's end. TrimTabs said expected inflows in
December would be in the $20.2 billion range with only $8.6B remaining in U.S.
equities while $11.6B would be heading overseas. This is well above prior years
and a key reason why the U.S. market is floundering.

Commodities
have also taken their place on the retail stage in the U.S. markets.
Instead of having to use separate brokers and different accounts with reams of
complicated paperwork the rules have changed. Many major brokers are offering
combination accounts where the various futures contracts can be traded as simply
as trading stock like IBM and GE or options on stocks or indexes. With the
greater volatility and higher leverage the futures markets have also been
attracting traders away from
conventional equities. Metals have also been very
attractive with copper and titanium taking their places with silver and gold as
strong gainers for the year. Steel prices soared with the global construction
boom and traders participated using individual stocks not normally known from
multi month moves.

Table of Commodity Gains

However,
2005 will be known as the year energy caught fire. Oil prices jumped
from $40 in January, already up strongly from the $27 low in 2004, to more than
$70 in the aftermath of Katrina. Natural gas prices more than doubled from their
January low of $6.53 to trade over $15 as huge amounts of U.S. production was
taken offline in the Gulf. More than 2.3bcf is still offline and much of that
could be offline until Q2. While prices for both commodities have declined
significantly
from the highs they are still holding above the yearly average of
$57.38 with oil at $61 and natural gas at $11.25. OPEC appears to be headed for
a production cut at the end of January of at least one million bbls and the
future is clear to those watching the proceedings. Prices are not going much
lower with the average price of oil in 2006 expected to be $58.46 according to a
survey of energy analysts. It should be no surprise that the S&P Oil and Gas
sector rose +38% for the year.
Retail investors piled into the sector iShares,
Holders and SPDRs and were rewarded with spectacular gains through year-end.

Energy iShares, Holders and SPDRs

2005 could also be called the "Year of Takeovers." According to the bean
counters that keep records of these things more than a trillion dollars in
takeovers
either occurred or were announced. The list below is only a
representative few but they amount to nearly $300 billion in ten deals. This is
a massive amount of money and shows how much corporate cash had accumulated but
also suggests that valuations had improved significantly enough to stimulate
these transactions. Conversely there is another train of thought that suggests
corporations had topped out on organic growth and cost savings and were forced
to shift to acquisitions to maintain
forward motion. $277 billion of the
acquisitions were cash takeovers of public companies and that topped the $231
billion record set in 1999.

Top Ten Acquisitions Announced in 2005

There was so much excess cash stuffing the corporate coffers that stock buybacks
set a new all time record of more than $456 billion. This shattered
previous
record of $312 billion set in 2004 by +46%. 728 companies bought back shares in
2004 compared to 1012 companies in 2005. Historically whenever record amounts of
money were used for buybacks the markets moved higher according to TrimTabs.com.
Not so in 2005. According to Charles Biderman of TrimTabs.com investors did not
see the buybacks as evidence of a strong domestic economy. They saw the buybacks
as evidence that companies did not have any better use for the money. CapEx
spending was not especially strong and they had to do something with the money
to keep shareholders happy. If you are not growing revenue or making
acquisitions that will help future growth then buying back shares seems to be
the right thing to do. Investors were not impressed. This perceived lack of
growth potential helped to push investors into those investments in other
countries I outlined above. Growth is growth regardless of country. To
illustrate this lack of investor interest
Exxon bought back a massive $13
billion in shares and the stock only gained about +10% for the year. Microsoft
repurchased $9 billion but its shares ended flat. The key to attracting American
investors is growth and that was noticeably absent from the economic picture
despite a +3.5% GDP.

This one six-dollar stock has the potential to pump your portfolio. Find out what company we are talking about, including recent insider transactions that make it all the more compelling. Click here for our special report revealing this stock and four others:

Also
sucking money out of equities was a very strong IPO calendar in 2005. Every
new issue takes money away from the rest of the market. Google, who launched
their IPO in Aug-2004 shot higher throughout 2005 adding more than double its
$59 billion market cap as of 12/31/2004. With a current market cap of $123
billion that was a huge blackhole sucking money out of other stocks as investors
abandoned other equities to jump on the Google train. The IPO bubble is only
getting stronger with 140 already registered for 2006 for an estimated $23
billion. Thomson Financial thinks there will be as many as 300 in 2006 with more
than a $50 billion price tag.

If 2005 was a dog for everything but energy stocks how is 2006 going to rate? If
I knew beyond a shadow of a doubt I would be mortgaging everything I owned to
bet on that outcome. Unfortunately nobody has that proverbial crystal ball but
there are quite a few analysts betting their reputations
this week. Various
analysts were interviewed publicly or published their expectations for 2006. The
list below also includes an unscientific survey of 112 NYSE floor traders. Their
average target for 2006 was 1293 for a +3.8% gain. However, fully one third of
those traders were bearish and expected a rocky year. For five of the last six
years traders were more bullish than the actual market the next year. On the one
year they were bearish the Dow rose +25% the following year.
This illustrates
perfectly that the markets exist only to frustrate the most people possible in
any given year. Despite one third of those being surveyed being bearish the
survey still projected that +3.8% gain for 2006 to 1293. If those traders have
historically been too bullish then it would suggest something less than 1293 for
2006.

Table of Broker Targets for 2006

The vast majority of analysts taking a position in print agree mostly with a
target in the 1300 range with those three companies above with estimates at 1400
standing well out of the crowd.

About the only thing most agree on is that the energy sector will continue to
provide above average returns. With OPEC likely to support a price in the mid
$50 range the odds of oil retreating under $50 are slim, always possible but
slim.
Energy companies are still seeing their stock being valued using oil in
the $30 range. This suggests there is still plenty of room for price
appreciation. Does anybody really believe ConocoPhillips is overpriced with a PE
of 7? How about ChevronTexaco at 9 or even ExxonMobil at 10? The price of energy
stocks will continue to rise but maybe not at the meteoric rate we saw in the
summer of 2004. They will rise because very few companies outside the energy
sector are growing earnings
at rates of +40% to +85% or more. Of course there is
always the expectation for Peak Oil to arrive in 2007 to keep the speculators
active.

Crude Oil Chart - Daily

I am sure there will be some more consolidation in the industry simply because
it is cheaper to buy reserves than find them. There are plenty of companies with
valuations far
below acquisition levels. For instance Apache (APA) has a market
valuation of only $13 per bbl of reserves and very strong management. Chesapeake
Energy (CHK) has been on an acquisition binge but it may be just to keep
potential acquirers of itself off balance. CHK controls the third largest
reserves of natural gas in North America and yet has a market cap of only $11
billion and a price to reserves of only $17 a bbl. Coincidentally insider buying
at CHK is out of sight. Since Dec-14th
the Chairman and the President have
purchased 2,272,000 shares in the open market for something north of $72 million
dollars in 14 separate transactions. Personally if they are buying their own
stock at $32 in that quantity I seriously doubt it is going much lower. If they
are willing to invest $72 million near the top of the market what does that tell
you about their expectations?

The downside for 2006 remains the homebuilders and the housing sector in
general. Even
if the Fed rests at something under 5% there is still a lot of
negative sentiment about the sector. Several years of speculative excess has
pumped prices to extreme levels and inventory for sale is growing quickly. Once
the speculators finally accept reality there could be a sudden downdraft.
Inventory numbers for existing homes for sale were just released last week at
2,903,000 and that is a +31% increase over the same period in 2004 at 2,214,000.
New homes for sale were reported
at 503,000 a week earlier and +83,000 over
2004. Add those numbers together and you have a total of 3,406,000 homes for
sale, up +29.4% from 2004. Since new households only increase at a rate of about
1.2 million per year there is a lot of inventory for sale. Many of those new
households will be apartment dwellers making the inventory numbers even more
dramatic. I would be very surprised if the homebuilders rise from the dead in
2006. However, many builders have backlogs up to 12 months
out so they will
still continue to produce profits, just not at the rate of past years. Since
some estimates say new homes account for as much as 50% of our current GDP
levels that will make it hard for GDP to post any gains in 2006. (Thanks Joe for
the heads up)

On the positive side the Fed is likely to quit raising rates in March if not
before. This is typically an all-clear signal for the markets BUT it is also
typically a signal that the economy is in good shape.
Our economy is far from
ready to sprint higher when the Fed moves to the sidelines. Besides the expected
drag from the housing sector we will have the continued drag from higher energy
costs. Earnings from Q4 will be the first round where the real impact from
record energy prices will be felt. I suspect there will be quite a few companies
use the energy excuse for lackluster earnings. This will continue to drag on the
economy simply because everything made or transported in the U.S.
is impacted by
those higher prices. Few analysts have connected the dots that $55 oil and $10
gas is not going away and anyway you count it that is a significant earnings
drag over 2004 levels.

Earnings are expected to decelerate into single digits after a very long run of
consecutive double digits quarters. This will force some PE compression and
probably give us another year of range bound trading. The S&P spent most of 2004
in 1075-1150 range. The Q4 rally in
2004 pushed the S&P above that range to
establish a new range from 1150-1250. That range held all year until the same Q4
breakout occurred in 2005. These two years of consolidation from the +350 point
rebound out of the 2002 bottom has pushed the S&P about as far as it can push
without some help from somewhere. We already know the indexes would have been
severely negative for all of 2005 without the +38% jump in the energy sector.
Still they just broke even for the year.

With
2006 coming under attack from all directions it is highly unlikely there
will be a breakout soon. I believe traders are going to be focused on the Fed
and on energy. The last Fed meeting for Greenspan will be Jan-31st and odds are
good he will leave with a 4.5% Fed rate. Bernanke will then take charge with his
first meeting on March 28th. If the Fed does not change the statement to a
neutral position in January then all eyes will be on Bernanke's first meeting in
March.
There are mixed feelings now on whether he will hike again to prove his
manhood or go soft on the markets with a wait and see position. This should be
the key pivot point for 2005. Regardless of what the markets do for the next 90
days that should be the make or break moment for 2005. Of course all bets are
off should the Fed stand aside in January. That could light the rally fire
before the energy grinch has a chance to damage investor sentiment over
earnings.

Dow Transport
Chart - Weekly

Personally I believe January could get rocky. Last week should have been a
wakeup call for everyone. The tape painters tried to recover from the Monday
massacre but they were either under funded or too scared to make much difference
to the outcome. Wednesday and Thursday traders were walking on eggshells afraid
the next tick
was going to be the one that setoff the next sell program. That
tick finally hit at 3:PM on Thursday and the selling continued into lunch on
Friday. I mentioned on Tuesday that I expected 10725 to be defended by the tape
painters and that was exactly where they drew the line. They again tried to
resurrect the indexes in the last hour of trading and probably got some help
from traders covering shorts in the last hour but they had the props kicked out
from under them once again by a
sell program at the close. I told you last
Sunday my calendar had a skull and crossbones on it for Friday and my fears came
to pass. It worked out well for me and anybody following my Tuesday night
suggestion to short any rally. Remember the VIX chart from last Sunday when the
VIX had fallen to 10.27 and very close to a new low? Well, it only rebounded
slightly despite the volatility for the week. This suggests far too many traders
are still too bullish.

VIX Chart - Weekly

I don't think we need to look any farther into the future than next week. There
should be plenty of volatility and opportunity for everyone. If you are a bull
just surviving the week may be a trick. While nobody can predict the future
exactly I would say the setup has the classic earmarks of a fund dump. I
reported earlier that funds received
inflows of $7.7 billion in the two weeks
ended on Wednesday. Obviously they did not put it into the markets. This should
tell us something about next week's chances. Funds have been holding their
breath trying to escape 2005 with what little profits they have intact. They
probably dressed up their portfolios over the last few weeks with a few winners
to make themselves look like heroes but come Tuesday morning all bets are off.
They are free to liquidate at will and then shift back into
their less visible
positions once the dip ends. Some of those positions will be in energy futures.
If you want to know which stocks they will be dumping next week you only need to
look at the winners for the last two months. Quite a few have already been taken
to the woodshed like MHC, PGR, CI, PD, JCOM, UNH, ADSK and GMXR. This is only a
taste of what we could see next week. Don't think the energy stocks will be
exempt either. The run up in futures we saw the last two days to push
crude back
to $61 could have been just tape painting designed to keep energy stocks from
buckling into year end. The inverted yield curve has gotten enough press over
the last week that anyone currently invested should have thought at least once
about lightening up on their positions just in case the warning was accurate.

SSOX Chart - Daily

The
Transports appear poised to nose dive to 4100 with very little effort after
two separate attempts to hold 4275 failed. It is not that the rest of the
indexes will need any help moving lower next week but a collapsing
Transportation Index will speed up the drop. The SOX collapse under 475 is all
the asdaq stocks will need as a warning flag that trouble is near. The SOX
found buyers at 475 on Friday but I believe it was tape painters trying to avoid
free fall. My suggestion
to you this weekend is to tighten up stops on any long
positions and be prepared to go to cash or go short on any weakness on Tuesday.
In theory the Santa rally continues through Jan-4th but since Santa had a sleigh
wreck on his way to Wall Street I would not count on an upside surprise. If we
do get one I would consider it a gift of a better entry for a new short
position. I hope I am wrong about my bearish outlook but that is the way I am
playing it. Plan your trades and trade
your plan but be ready to abort that plan
if your bias turns out to be wrong.